Keys to the cities

Tax-free municipal bonds offer value vs. Treasurys

SAN FRANCISCO (MarketWatch) -- Rising U.S. interest rates are putting a spark into typically straight and safe municipal bonds, enhancing their appeal even to investors in middle tax brackets.

The most attractive values in muni bonds now are intermediate-term securities that mature in eight to 12 years, investment advisers say. A typical, high-quality, 10-year muni bond yields about 85 percent of a comparable Treasury bond yield, but munis trump Treasurys on an after-tax basis.

"Intermediate is really the sweet spot," said Marilyn Cohen, president of Envision Capital Management, a Los Angeles-based money manager. "Long-term rates have rallied significantly more than intermediate-term rates."

Treasury bond income is federally taxable, while muni income is exempt from federal and, in most instances, state taxes. At current rates, that makes muni bonds -- issued by states, cities, school districts and other public agencies -- a better deal not only for the wealthiest investors but also for taxpayers in lower brackets.

For example, a triple-A rated insured 10-year muni bond yields about 3.5 percent on average, less than the 4 percent yield of a similarly maturing Treasury. Other types of munis will carry lower credit ratings with higher yields, and some issues are uninsured.

The muni generates lower relative income, but the after-tax yield to an investor in a 28 percent federal bracket would equate to a tax-equivalent yield of 4.86 percent. Top-tier taxpayers would fare even better -- the after-tax yield for someone in the highest 35 percent bracket would be 5.38 percent.

And that just factors in federal taxes. Add state taxes, especially for high-toll states like New York, California, Massachusetts and Minnesota, and munis present a clear advantage over Treasurys.

"If you're in a relatively high tax rate, you go with a muni," said Jim Boucher, a portfolio manager at investment adviser SDR Capital Management in San Francisco. "Many municipal bonds are triple-A rated and insured. The default risk is minimal."

Figuring a muni bond's after-tax yield takes just a quick calculation: Simply divide the bond's yield by 1 minus the marginal tax rate and compare that to a similar Treasury. To find the tax-equivalent yield of a 3.5 percent muni bond for a taxpayer in the 33 percent bracket, for instance, divide the yield by 1 minus 0.33, or 0.67, for an after-tax yield of 5.22 percent.

Yield signs

Bond prices typically fall as interest-rates rise. But longer-term bond yields have stayed surprisingly low in the face of short-term U.S. interest-rate hikes. Meanwhile, the stronger economy has boosted state and local revenues, improving munis' fundamentals and returns relative to Treasury bonds.

Munis tend to outdo Treasurys at such times, but underperform when rates decline. That's in part because munis' lower relative pretax yield reduces their sensitivity to interest-rate changes.

Investors should be aware that munis aren't as liquid as Treasurys and frequently include a "call" provision, which permits an issuer to repay bondholders earlier than planned. If interest rates fall, issuers are likely to redeem their higher yielding bonds -- a risk that may be worth taking in a rising-rate environment or if the bond's earliest call date is several years away.

"Going forward, we like munis," said Jim Peterson, a vice president at the Schwab Center for Investment Research. "We expect to see the Federal Reserve continue to gradually raise rates, and municipalities look pretty good economically. If you think rates are going to rise, there's reason to favor munis."

But when should investors buy individual muni bonds, and when do diversified muni-bond mutual funds make more sense?

In this case, wealth matters. Highly rated, insured muni bonds can be purchased for as little as $5,000 each, but adequate diversification means holding at least 15 or 20 securities.

In addition, the markup or commission on a sale can be as much as 3 percent of the bond's original value, depending on order size. But unless a financial adviser is involved in overseeing the account, there are no ongoing management fees.

"If you're buying individual bonds, to achieve a significant level of diversification you have to have a more sizeable amount of money," said Michael Decker, a senior vice president at The Bond Market Association. "You're going to have to buy bonds from at least several different issuers."

Knowing what to buy and how much to pay just got somewhat easier. Prices of muni bonds are available online within 15 minutes of a trade at the Bond Market Association's Web site, investinginbonds.com. The free service, launched last week, complements an online site with a substantial amount of easily understood advice about muni-bond investing. See related story.

In contrast, a muni fund requires a small minimum initial investment and offers broad diversification and professional management that looks for bargains and moderates risk. But funds come with annual expenses and a portfolio's net asset value will vary with interest rates since funds, unlike individual bonds, have no definite maturity date.

Investors in high-tax states will want to look at their home-state munis or funds, while residents in places that are friendlier to taxpayers can look nationwide or buy national muni funds with generally higher yields.

"People in low- or no-income-tax states can go to any state and ferret out the best deal," Envision's Cohen said.

Cost is especially important when choosing a bond fund, Cohen added. "Stick with the no-load ones with the lowest expense ratios," she said.

National intermediate-term bond funds that investment-research firm Morningstar ranks among its favorites include offerings from giants Fidelity Investments, USAA and the Vanguard Group, all of which carry expenses below the category's 0.99 percent average.

The $1.8 billion Fidelity Spartan Intermediate Municipal Income fund
FLTMX, +0.00%
is a Morningstar top pick for diversity, low-risk and above-average return, plus an expenses ratio of 0.43 percent.

The $12.3 billion Vanguard Intermediate-Term Tax Exempt fund
VWITX, +0.00%
lives up to its parent's thriftiness, charging just 0.14 percent annually for a portfolio that Morningstar praises for its veteran management and above-average return.

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